Stock markets in developed countries are particularly sensitive to interest rates movement. The main reason is that they function as “debit” societies much more than the rest of the world, i.e. they finance their spending by borrowing against their future earnings, instead of using the cash they own. Accordingly any increase in interest rates has a serious impact on their consumers, business organizations, and investors. When rates increase, consumers and businesses reduce their expenditures in order to trim their cost of debit increase. With high interest rates, business profitability goes down but the return on bonds goes up. This prompts many investors to move their funds from stocks to bonds.
In fact the Federal Reserve (Fed) and the European Central Bank (ECB) meet regularly to make decisions regarding the interest rates of their respective currencies — US dollar and the euro. Recently the Fed increased interest rate on the dollar by 0.25 basis points to 1.25 percent, and provided a signal that it will maintain a gradual or “measured” rate hike in the future. Although the current rates are at forty-year low, however the recent action and official statement started a ripple effect in the financial markets, by scaring many investors and prompting them to sell their stock holding. ECB decisions are also done in harmony with the Fed actions.
Contrary to popular belief, periods of rising interest rates are not usually a disaster for the stock market, although rising rates and shifting Fed and ECB policies do affect stocks and sectors in important ways. Historically rising rates have caused sector rotation — institutions shift money out of so called “interest rate sensitive” sectors and into more stable defensive groups. That spells myriad opportunities for investors who understand how and why the rotation occurs.
The Fed and ECB normally hike rates when their economies begin to expand too rapidly, since rapid expansion can fuel inflation. Higher rates serve to cool the economy, as businesses become more reluctant to borrow money and fund expansion. The effect on consumers is even more drastic. Many consumer purchases are funded at least partially by debt. That includes big-ticket items like cars, houses, as well as smaller purchases like computers and furniture. Higher financing rates usually deter spending on such items. Consequently bond yield soars as expectation for future hikes mounts. Stocks of some sectors benefit from the above, while others loose.
The main losers are stocks of banks, REITs (real estate investment trusts), and utilities. Banks make money by attracting short-term deposits from consumers and lending that money out at higher long-term interest rates. The level of rates isn’t important to banks, since they make money on the spread between long and short-term rates. When the central bank hikes interest rates, short-term rates tend to rise more quickly than long-term rates. That means banks have to raise rates offered on money market funds and savings accounts, paying more to attract depositors. In such periods, banks’ cost of deposits tend to rise faster that their profits from lending, thus leading to a profit margin squeeze.
Investors tend to purchase REITs and utilities as income investments because they offer high dividends. However when rates rise, bonds begin to compete with dividend paying stocks for investors’ attention. Rising rates raise the cost of borrowing money. Since both of the above categories have to pay most of their earnings as dividends, high rates will increase the interest bill to service their debt.
The winners on the other hand are pharmaceuticals and consumer staples. Pharmaceuticals aren’t overly sensitive to either economic cycles or debt levels. Demand for healthcare products and services, does not change much from year to year, even during severe recessions. And while most people finance car and home purchases, drugs and doctor visits are covered by medical insurance. Another plus is that most developed nations are rapidly ageing as birth rates drop and life expectancies rise. Because older people require more drugs and medical services than their younger counterparts, we expect to see a spectacular rise in demand for all sorts of healthcare products in the coming years.
As with pharmaceuticals, consumer staples products are insensitive to consumer debit burdens, since very few people finance purchases of food and consumables. In addition, if the economy were to slow down in the coming years, then this wouldn’t be a problem either, since demand for most staples usually remains steady throughout both good times and bad times.
(Salim J. Ghalayini is a professional engineer and a seasoned investor. He manages several investment accounts.)
